The future of tax treaty – the discussion of the applicability of MLI

What is MLI?

Multilateral Convention to implement tax treaty related measure to prevent base erosion and profit
shifting (Multilateral Instrument (MLI)) is a multilateral treaty that enables countries to swiftly modify
their bilateral treaties to implement measures that aimed to tackle multinational tax avoidance. Further,
the measures were developed as part of the Organization for Economic Co-operation and Development
(OECD)/G20 Base Erosion and Profit Shifting (BEPS) Project.

Countries which sign the MLI can adopt the recommendation set out in BEPS Action Plan 2 (Hybrid
Mismatch Arrangements), Action Plan 6 (Treaty Abuse), Action Plan 7 (Avoidance of Permanent
Establishment), and Action Plan 14 (Dispute Resolution) without entering bilateral negotiations which
takes long process generally. According to OECD, MLI will not replace the existing tax treaties
completely. Instead, MLI will apply alongside the existing tax treaties.

MLI provisions only changes for ‘Covered Tax Agreement’ (CTA). In this essence, CTA is tax treaty
which is in force between the Parties (countries) to the MLI and for which both Parties have made a
notification that they wish to modify the agreement using the MLI framework. Thus, if only a country
notifies its tax treaty as CTA, whilst its partner country does not do unlikely action, then, the modification
of tax treaty cannot be conducted under MLI mechanism.

Where is Indonesia position and when it is effectively applicable?

As a part of G20 countries, Indonesia has shown its commitment to participate in avoiding BEPS by
signing MLI on 7 June 2017 and was continued by issuing President Regulation Number 77 Year 2019
(‘Perpres-77’) dated on 12 November 2019. Further, OECD announced that MLI for Indonesia is
effectively applicable starts on 1 August 2020 due to Indonesia had deposited its instrument ratification of
MLI on 28 April 2020.

Under MLI mechanism, Indonesia takes three kinds of position. In this essence, Indonesia has: (i) adopted
minimum standards of MLI, (ii) adopted optional Articles within MLI, and (iii) made reservation for
several Articles within MLI. First, Indonesia has adopted minimum standards of MLI, they are Article 6
(Purpose a Covered Tax Agreement), Article 7 (Prevention of Treaty Abuse), and Article 16 (Mutual
Agreement Procedure).

Second, Indonesia has adopted optional Articles within MLI, they are Article 4 (Dual Resident
Transactions), Article 8 (Dividend transfer transactions), Article 9 (Capital gains from alienation of shares
or interest of entities deriving their value principally from immovable property), Article 11 (Application
of tax agreements to restrict a party’s right to tax its own residents), Article 12 (Artificial avoidance of
Pemanent Establishment (PE) status through commissioners arrangements and similar strategies), Article
13 (Artificial avoidance of PE status through the specific activity exemptions), Article 14 (Splitting-up
contracts), Article 15 (Definition of a person closely related to an enterprise), and Article 17
(Corresponding adjustment).

Third, Indonesia made reservation several Articles within MLI, they are Article 1 (Scope of the
Convention), Article 2 (Interpretation of terms), Article 3 (Transparent entities), Article 5 (Application of
methods for elimination of double taxation), Article 10 (Anti-abuse rule for PE situated in third
jurisdictions), Article 18-26 (Arbitration), and Article 27-39 (Administration of MLI).
What are restrictions compared to current without MLI provisions?

MLI will impact to source country, particular for developing country. This may be acceptable due to
source country has plenty of natural resources. But, it may impose high tax rate for income gained from
its country as it has to fund state’s expenses. As a result, there is a possibility that tax treaty made by
source country and its partner country is abused either by its partner country or other country that is not
entitled to gain benefit from tax treaty made between source country and its partner country.

If MLI provisions are not ratified, source country is not be able to address treaty shopping, to address the
abuse of taxable presence requirement in the definition of a PE or to address other treaty-related profit
shifting. So, in this essence, source country cannot preserve its taxing right towards profits that gained by
other countries. Whereas, the ideal taxing right is profits are taxed where the economic activities
generating those profits are performed and where value is created.

Impact of MLI provision to taxpayers

As mentioned before, MLI has Article 7 that governs about prevention of treaty abuse. Further, under
Article 7 of MLI, source country has three options to choose, they are: (i) a combined approach consisting
of a Limitation on Benefits (LOB) provision and a Principal Purpose Test (PPT), (ii) a PPT alone (default
option), or (iii) an LOB provision, supplemented by specific rules targeting conduit financing
arrangements.

MLI will impact toward how the mechanism of PPT works when the Parties ratify MLI. This is caused by
the essence of PPT is it disallows the principal purpose of establishing a particular transaction is aimed to
obtain tax treaty benefits either directly or indirectly. Thus, a pure conduit company with no commercial
substance which makes transaction that aimed to gain benefit purely from the favorable terms of a
double-tax treaty between two jurisdictions would likely not qualify for tax treaty benefit once MLI is
ratified.

Further, useful actions that may be taken by country (in this case multinational company) that has PE in
source country in order still can obtain tax treaty benefits though MLI is ratified are: (i) identifying and
quantifying the treaty benefit from transaction and comparing that benefit to a situation that would not be
solely tax driven, (ii) identifying and quantifying the business, for non-tax, reason for undertaking the
transaction and the choice of location of the PE, (iii) critically evaluating the evidence to assess the
weight of the business against tax-related purpose as well as considering of any other realistic alternatives
that may be identified, and (iv) having the ability to show that there is substance or economic activity in
source country (selected jurisdiction).

Key points:

 MLI has good effect for country ratifies MLI provisions. In this sense, each country can strengthen its
taxing rights toward the establishment of PE. This advantage is utilized by Indonesia which can be
seen through the issuance of Perpres-77 and had been deposited its ratification instrument so MLI is
applicable on 1 August 2020
 Nevertheless, MLI also offers the impact that should be concerned related to the mechanism of
working of PPT. In this essence, PE acts as taxpayer shall show its evidence that it has economic
substance in jurisdiction where it is established. In addition, PE also should scrutinize aspects related
to its business transactions in order not be deemed solely to obtain tax treaty benefits.

Sources: Oguttu (2018), Burger and Dolan (2018), Tanenbaum and Kavanagh (2017), Korving and Hulten (2018)